As Ireland has already shown, pills you don’t need to have a big proportion of euro area GDP to destabilise the currency area. Cyprus is doing a stellar job of reinforcing that point. The Cypriot crisis has evolved as follows, viagra a huge banking sector (over 800% of GDP) has been taking in deposits from Russia, medicine China and others, mainly due to their dubious money laundering procedures. Like any bank that has plenty deposits it lends money out or buys financial assets.
While the ordinary loan losses on mortgages and the like have not been extraordinarily high, Cypriot banks were holding Greek government bonds. When Greece defaulted (well restructured anyway) holders of their bonds got less than half of their money back. Bank of Cyprus alone lost €1.3bn on the bonds. This has left the banks unable to meet their obligations and require cash fast. To make a bad job worse the Cypriot Government is struggling to raise funds for its own ongoing deficits (mainly due to uncertainty about the costs of the banking collapse).
So the Cypriot banks and Government both need to find funds quickly. Initially, the Cypriot Government went cap in hand to the troika seeking bailout funds which they could then use to recapitalise the banks and to fund ongoing deficits. Essentially this would be the Irish solution, the Government is given huge loans and uses the money to fix the banks. The problem was that to do so the sum of the bailout would be so large (circa €16bn) that the government would inevitably have to default on its present bondholders (Cypriot GDP is only €19bn). The Troika wouldn’t tolerate another public default and hence said they would only lend a maximum of €10bn and that they would have to find the other €6bn themselves.
The alternative would be for the Troika to lend Cyprus the €17bn on the understanding that they would not get fully paid back. This would be considered monetary financing (where a central bank prints/creates money to finance a state) and hence was not considered. So the Cypriots needed to come up with €6bn quickly. The Cypriot banks were unusual in that most of their funding was deposits rather than bonds unlike the Irish banks, so there was no big pot of gold to be gained from burning bondholders and depositors would have to take a hit.
Initially this was to be done by taxing/levying/extorting bank deposits. 6.75% would be taken from accounts with less than €100,000 and 9.9% from those with over €100,000. This is despite the fact that there is a guarantee of all deposits up to €100,000. This proposal was rejected by the Cypriot parliament and now funds are to be raised through a new solidarity fund. It is important to note however that the ECB was fully supportive, in fact encouraging this action. It is still unclear if the necessary funds will be raised in time.
From an Irish perspective, this crisis reveals a change in stance from the ECB in particular, which it seems insisted that almost all bondholders be paid out in full despite the insolvency of the Irish banks. In the Irish case almost all bondholders and all depositors were paid in full pushing public debt levels to unsustainable levels. However, last week the EU/ECB/IMF insisted that the state not take all the liabilities of the banks on, as it would lead to unsustainable government debt levels. This is a remarkable change in policy, which could give the Irish government good cause to seek retrospective compensation for the costs incurred ensuring all bondholders and depositors were paid in full.